Valuation of proved vs. probable oil and gas reserves

Abstract

Oil and gas reserves are the most important assets of oil and gas companies. A source of confusion for investors in oil companies, is that reserves quantities and values are uncertain estimates. Reserves are typically classified according to probabilities of recovery from underground reservoirs. All US-listed companies are required to disclose proved reserves but not probable reserves, thus leaving out potentially important information for investors and financial analysts. This study addresses the impact on market valuation of various classifications of reserves amounts. Using a data sample of 94 companies that do disclose information on probable reserves, we compare the relation between three classifications of reserves and oil company returns. While we find that information on probable reserves do not have an impact on stock returns measured over the entire time period, this is not the case since 2009, coinciding with the onset of the shale gas revolution.

Keywords:

• oil and gas reserves
• proved reserves
• probable reserves
• value relevance
• oil company valuation
• stock returns
• valuation
• Shell
• Exxon
• Chevron

Public Interest Statement

This paper investigates the relationship between oil and gas reserves and market valuation of oil and gas companies, a topic that is of interest to investors and analysts. It is well known that financial markets can react considerably to substantial changes in oil and gas companies’ reserves. Oil and gas reserves are typically classified according to probabilities of recovery from underground reservoirs, such as proved (highest), probable and possible (lowest) reserves. The US Securities and Exchange Commission require that oil and gas companies only disclose one of these, proved reserves. We conjecture that information on also other reserves measures, such as probable and possible oil and gas reserves, could have an impact on oil company stock returns. Our results suggest that proved developed reserves are the main type of reserves used by investors to forecast future cash flows. However, we find that investors react differently to changes in probable oil and gas reserves, and especially after 2009, coinciding with the shale gas revolution.

Acknowledgments

We wish to thank the participants at the IAEE International Conference in Bergen in 2016, as well as an anonymous reviewer for constructive comments. We believe their input have greatly improved our initial manuscript.

Notes

1. Reserves in the US can also effect wealth of individuals owning oil and gas assets directly, not only through stock exchange listed companies (Fitzgerald & Rucker, 2016).

2. Under the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards (SFAS) No. 69 (FASB, 1982), the amount of reserves was estimated using oil and gas prices at the fiscal year-end; while under the current rules of FASB Accounting Standards Codification Topic 932 (FASB, 2010), the annual average of the monthly average oil and gas prices are used.

3. See also Bindemann (1999) and Kretzschmar, Misund, and Hatherly (2007) for a discussion on the impact of production sharing agreements on accounting disclosures.

4. SPE combines the reserves into 1P (proved), 2P (proved plus probable) and 3P (proved plus probable plus possible) and define probabilities of 90, 50, and 10% of final recovered reserves exceeding the 1P, 2P, and 3P amounts, respectively.

5. Reserve amounts can be increased by enhanced oil recovery techniques (EOR) (Sevin & Ortega, 2016).

6. Early on there were inconsistencies between the 1981 SPE and 1978 SEC definitions. This led to efforts to align the definitions which culminated in the 1997 SPE reserves definitions for proved, probable, and possible categories (Harrell & Gardner, 2005). While 1997 SPE and 1978 SEC proved reserves definitions are very similar, the SEC regulations were generally considered to be more restrictive. In 2008, the SEC rules were updated and are now consistent with SPE’s (SEC, 2008).

7. A strand of the literature also examine the value relevance of reserve amounts and net present values, i.e. regression of market values on reserves in levels form (see e.g. Berry, Hasan, & O’Bryan, 1998; Bryant, 2003; Cormier & Magnan, 2002; Misund et al., 2008).

8. Academic studies have addressed the divergence of oil and gas prices during this period (see e.g. Asche, Oglend, & Osmundsen, 2012; Erdõs, 2012).

9. Shale gas economics is also affected by costs, including drilling costs, completion, and productivity (see Ikonnikova, Gülen, Browning, and Tinker (2015)) for a study on shale gas economics and the well level.

10. Assuming that the Rational Expectations Hypothesis holds.

Additional information

Notes on contributors

Bård Misund

Bård Misund is an associate professor of Accounting and Finance at the University of Stavanger Business School. He has 10 years of industry experience from commodities companies. Before joining academia, he worked as an economic analyst and an advisor to the Norwegian oil and gas company Statoil ASA. His research includes commodity price behavior, the spot-forward relationship in futures markets, determinants of commodity firm stock returns, financial statement analysis and valuation of oil and gas firms.

Petter Osmundsen

Petter Osmundsen is a professor of Petroleum Economics at the University of Stavanger, where he is the head of the Section of Petroleum Economics. He has a PhD from the Norwegian School of Economics (NHH). In 1992/1993, he was a research fellow at the Massachusetts Institute of Technology. He has previously held a position as an associate professor at NHH. Homepage: WWW.UiS.no/Osmundsen.